‘Desperate’ Pension Plans Move to Alternative Investments

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McKinsey & Co. has been getting a lot of attention for a new report contending that alternative investments, whose popularity has surged recently, are not a risky fad that may soon run out of steam, as some financial advisers are telling their clients.

Whether to invest in alternatives, and if so, how much, is a key question these days for corporate pension-plan sponsors, a historically risk-averse group. Some plans have improved their funded status dramatically in the past couple of years, but many others continue to wallow at a 75 to 80% funded level. That’s a risky place to be, with Baby Boomers starting to retire in droves.

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By the broadest definition, alternative investments are anything other than stocks, bonds and cash. McKinsey notes that the category includes investments in such vehicles as hedge funds, funds of funds, private-equity funds, real estate, commodities and infrastructure.

Such investments have been hot for years. The compound annual growth rate of alternative investments was 10.7% from 2005 through 2013, almost twice the 5.4% CAGR racked up by traditional asset classes, according to McKinsey.

To skeptics, the enthusiasm for alternative investments is way out of whack. Objections include their complexity, their typically high investment-management fees — they now account for almost 30% of asset-management-industry revenues while comprising only 12% of industry assets, McKinsey says ­— and their returns, which have significantly lagged those provided by equities in recent years. That was especially so in 2013, when the average hedge fund produced an 11% return while the S&P 500 index soared by 30%, McKinsey notes.

But based on a survey of 300 institutional investors, McKinsey forecasts that new flows into alternative investments, as a percentage of assets, will grow at an average annual pace of 5% over the next five years, dwarfing the 1 to 2% expected pace for traditional investments. To some, that’s not really news. “There is nothing controversial or unexpected about the McKinsey report,” says Nicholas Tsafos, a partner at accounting firm EisnerAmper.

Tsafos may not be completely unbiased, as his clients are mainly hedge funds and private-equity firms. But in that capacity he’s a front-line observer of the demands corporate pension plans are facing, with immediate funding needs clashing with long-horizon obligations. “The stock market has done relatively well in the past few years,” he says, “but pension plans have a lot of payouts due in the near future. So they’re looking to get into alternative investments that will meet their current funding needs but offer a long-term outlook at the same time.”

McKinsey suggests that the bull market, now more than five years old, can’t be expected to continue indefinitely. Indeed, the report says institutional investors that manage money for pension plans are moving more money into alternatives out of “desperation.”

“With many defined-benefit pension plans assuming, for actuarial and financial reporting purposes, rates of return in the range of 7 to 8% — well above actual return expectations for a typical portfolio of traditional equity and fixed-income assets — plan sponsors are being forced to place their faith in higher-yielding alternatives,” McKinsey writes.

But, the consulting firm notes, the rapid growth of alternatives is not simply the result of investors chasing high returns. “Gone are the days when the primary attraction of hedge funds was the prospect of high-octane performance, often achieved through concentrated, high-stakes investments. Shaken by the global financial crisis and the extended period of market volatility and macroeconomic uncertainty that followed, investors are now seeking consistent, risk-adjusted returns that are uncorrelated to the market.”

(Editor’s note: McKinsey provided its report to certain media organizations but by press time had not posted it on the Internet, so no link to it was available.)